Counterparty Risk

One topic that has been hinted about on the periphery during the current market difficulties is counterparty risk. As a person in charge of running a fixed income trading desk in emerging market and international securities, counterparty risk was always at the forefront of most of our dealings, even after the concept fell out of vogue elsewhere in the investing world. When I was dealing with counterparty risk on a daily basis, my primary concern was whether the firm on the other side of the trade was going to be there to pay/deliver on settlement date. The problem was that many of the firms in my area of the business were not subject to the laws or rules that you would normally take for granted when dealing with counterparties in developed markets. We would look at financials of a counterparty and make decisions on how much we were willing to trade with them accordingly. The financial statements we were given, however, were generally unaudited and not-GAAP compliant. There was always some leap of faith when doing a transaction such as this, but if we stayed on top of things and remained constantly vigilant, I felt we were doing the right thing, even though it probably cost us some business. (As an aside, we had very few problems over the years. Given the KYC issues we had to plow through, that stands as a testament to the people that worked for me.)

Today, however, we have an altogether different problem. The counterparty risk that exists in the multitude of derivative markets, particularly the credit default swap market, is of a different order. For example, if I bought $1 million of bonds from a counterparty who later was unable to deliver, my risk was somewhat limited. If this counterparty did the same thing to 20 others, all of the risk was spread out. We may not like the short-term consequences, but business would go on. Ten years ago, when LTCM was teetering, the concern was that a failure of a counterparty of that magnitude would have a cascade effect on the rest of the market. For a time, liquidity seized up and rumors were rampant. Then the Fed stepped, engineered a bailout and an orderly liquidation of LTCM. This worked because, despite the rumors, the rest of the financial system was sound.

Fast forward ten years to today and counterparty risk is taking center stage once again. The notional amount of derivative products outstanding, even after the so-called reduction of risk that has occurred over the last six months, is mind boggling. The numbers that are floated around, in the trillions of dollars, are probably low estimates. Think of counterparty risk in this instance as a very long chain. The chain is only as strong as its weakest link. If a small link fails, the rest of the chain can get together to weld it shut. If a big link fails, or importantly, a bunch of different links fail simultaneously, the whole the chain falls apart. The consequences of such a failure would be quite unthinkable.

The Fed started to get serious about this a few years ago when it put together a framework that would clear up the settlement backlog. At one point, trades would go months or years without being confirmed. While there is a better handle on this now, my problem of KYC from the first paragraph has moved to center stage. The number of derivative counterparties has exploded with the growth of hedge funds. Given the reduction in leverage that has occurred already, it is amazing that a truly market debilitating situation hasn't already occurred as a result of lax controls of counterparty risk. Hopefully that means all that are responsible for monitoring counterparty risk out there are doing their job as well as we did.